The Hindu Business Line : Imperatives in corporate forex hedging

Today, the overall environment is quite conducive to Indian companies re-denominating their cost base in currencies which are depreciating against the rupee. Further, hedging of revenue foreign exchange flows has to be systematically carried out, says T. B. KAPALI.
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Two broad trends seem to be clear as the quarterly corporate earnings season rolls on. On the one side are companies whose operating margins have come under pressure on account of the rupee’s notable appreciation against the US dollar in the past 3- 4 months. Many traditional, low-profile exporters such as textiles as also the more high-profile ones such as IT have reported considerable strain on their realisations and margins. These are companies which have revenu e (in)flows denominated in the dollar.

On the other side are companies which have registered significant gains in ‘other income’ — arising from foreign exchange gains on their foreign currency borrowings which is a ‘capital’ account item in their balance-sheets. In some cases, the capital account gains have been high enough to offset the foreign exchange losses on the revenue account.

It will not be possible to “fix” the final cost of unhedged foreign currency borrowings for reporting on a particular balance-sheet date. But still, the level of realised foreign exchange gains on liabilities has been high and, importantly, the outlook for the rupee also is bright enough that companies which have borrowed foreign currency in the past year and a half have good justification for expecting further gains on this account.

Re-denominate the cost base

The broad message from these developments is quite clear. It is imperative for Indian companies which have significant revenue flow exposures in foreign exchange to move or convert all or at least a part of their capital liabilities into foreign currency exposures. This can be a broad financial management strategy as long as the appreciating rupee view continues to hold.

That is, as the revenue base is under pressure on account of the depreciation of the currency in which the revenues are denominated, the strategy should be to move the cost base also to the currency which is depreciating against the Indian currency. In other words, increasing levels of ‘dollarisation’ of the balance sheet should be the strategic response to sustained rupee appreciation.

Today, the overall environment is quite conducive to Indian companies re-denominating their cost base in currencies which are depreciating against the rupee. Not only is the direct external commercial borrowings market open to even mid-segment Indian companies. The Indian foreign exchange markets have also advanced enough for companies to “synthetically” access currencies which have lower rates of interest than the rupee and also importantly, which have good prospects of staying weak against the rupee.

Currency swaps

Currency swaps are the answer to those companies which are not able to access foreign currency liabilities directly. By means of a currency swap, a company which has a primary rupee liability on its balance-sheet, creates an off-balance-sheet foreign currency liability and undertakes to repay the foreign currency liability in exchange for receiving a rupee cash flow calculated (at inception) at a certain rate of exchange.

The rupee cash (in)flow would go to meet the company’s commitment on its on-balance-sheet rupee liability. In other words, a currency swap is basically a re-arrangement of the capital account cash flows of a company and leaves the company with a net foreign exchange liability. And, if as per expectation, the foreign currency has depreciated against the rupee from the levels at the inception of the swap, the company is a net gainer.

The swap procedure is fairly straight-forward and simple and a transaction can be set up very quickly, unlike conventional loan procedures. Through the currency swap, for example, a company can borrow indirectly in the Japanese Yen which has rates of interest of less than 1 per cent, since the swap leaves the company with a yen cash outflow finally.

Various permutations and combinations of the simple procedure outlined above are possible. Apart from factoring the differential rates of interest on the two currencies in question (the rupee and the foreign currency), which is fundamental to any transaction, these permutations can take account, for instance, of the amortising nature of the company’s original rupee loan, can be structured to match the intervening cash flows and have built-in options protection (to some extent) against the foreign exchange risk inherent in the swap.

The risk in this transaction/product is basically the same as the risk a company takes in borrowing foreign currency directly. As such, as long as the company has a view on currencies, a certain risk appetite and a risk management policy in place, it should be open to doing this product.

At the system level, the Reserve Bank of India places some restrictions on the quantum of such currency swaps (outlined above) which can be outstanding at a point in time for a single bank.

margin pressures

Liability management as indicated above will be a strategy with a medium-term objective. Many tier 1 and mid-segment companies have been employing this strategy though awareness is still not widespread and acceptance more so. But what causes concern is the possibility that Indian companies may not be actively hedging their short-term revenue exposures in foreign exchange.

A study of the quarterly results of some textile exporters (‘Rupee squeeze prompts textile cos to change tack’, Business Line, August 6) showed the operating margins of many companies declining by a few percentage points in the June quarter on the back of a 7-8 per cent appreciation in the rupee in the period between March and now.

It is very clear that if these companies had hedged their export receivables in March at the then prevailing levels (spot of around Rs 43.50 during end-March and higher around Rs 44.10 to the dollar earlier in the month and 3 month/6 month dollar premium of around 40-70 paise respectively), they could have avoided much of the margin pressure being witnessed currently, at least for a part of the overall financial year. The rupee has since strengthened around 7 per cent from its March levels and further costing/budgeting has to be from this base.

Such hedging does not appear to have taken place or it has taken place only sporadically. What needs to be stressed here is the criticality of systematically implementing hedging action as long as the market provides prices which cover a company’s budgeted costs/realisation prices. When companies begin to time their hedging action in the hope of bettering their realisations, they are moving from the realm of hedging to that of speculation.

markets underpricing risk?

What exporters and those with revenue (in)flows in foreign exchange need to note is the possibility that the markets could be underpricing risk generally. For instance, the dollar/rupee options market over the past six months has priced volatility in the underlying dollar/rupee exchange rate at 6-6.50 per cent annualised for 3 and 6 months options.

Now, at these prices, the signal from the options market was that the dollar / rupee spot rate would roughly move 1.50-3.50 per cent (on either side of the ruling spot rate) over a 3-6-month period.

But it is clear from subsequent price action that the realised volatility in the spot rate has been much higher than that implied in the options prices. The dollar has fallen 7 per cent (absolute) in just three months. The phenomenon of implied options volatilities being lower than actual realised volatilities has not been restricted to the Indian market alone. Globally, the options statistics on the major currency pairs are exhibiting somewhat similar trends. Of course, theoretically, actual volatilities could move to the advantage of Indian exporters also.

That is, the rupee could potentially depreciate also by more than what is implied in derivative prices. And it is also possible that there is a convergence between realised volatilities and that implied by ruling options prices. These are really imponderables.

The larger message for exporters is not to be lulled into inaction on expectations of a favourable market move. Hedging action has to be systematic and is to be implemented without delay as long as the market provides prices which cover their internally budgeted costs/prices.

T. B. KAPALI

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